Thursday, January 31, 2013

Liquidity premia in the detergent market

There is a recurringstory in the media that 150oz Tide detergent bottles are being used as money by criminals. It's a fun story and I can't resist using it to illustrate the idea of liquidity premia.

Assume that two types of detergent bottles are held in individual's inventories. Say that they are entirely similar except one bottle is harder to sell than the other. If some unexpected event were to happen, the liquid (excuse the pun) bottle of detergent can be easily sold so as to mobilize resources to deal with the event. The illiquid one can't. This ability to serve as a superior hedge against the unexpected is a valuable service.

Even if the unexpected doesn't occur, anyone holding the liquid bottle will face less stress and unease over time knowing that they are positioned to deal with any eventuality. A forward-looking individual will anticipate this stream of uncertainty-shielding services provided by the more saleable bottle, discount these streams into the present, and arrive at a value for the bottle's liquidity. This represents a liquidity premium. The more saleable of the two bottles will have a higher liquidity premium than the less saleable one and, as a result, it will earn a higher price in the market.

The source of the difference between the two bottles' liquidities and premia could be due to marketing. Say that one detergent producer has a larger advertising budget than the other and has succeeded in broadening the clientele for its bottles. The difference could also be a result of tradition. The incumbent is well-entrenched whereas the challenger is a foreign product and comes off as a bit odd. Or maybe the CEO of one of the companies has bribed the government to only purchase its brand, thereby rigging the market to make one detergent bottle more liquid than the other.

The differential between each bottle's liquidity premium isn't fixed. Marketing budgets can shrink or expand. Government officials may cease taking bribes or they may accept larger ones from the other side. Traditions fade. Alternatively, the public's perceptions about the world could change. If people become more worried about the future, they'll put more value on the liquid bottle's ability to shield from uncertainty than before. Both its liquidity premium and its price in the market will rise relative to the less saleable bottle. If, on the other hand, people feel less uncertain about the future, the liquid bottle's premium will shrink since its hedging role is less valued.

Can we arbitrage this premium differential? Selling the liquid bottle short and buying an illiquid bottle is a bet that the differential between the two will shrink. But if in the interim people become more worried about the future, or if the more liquid product enjoys an ad budget boost, then the differential will grow and the long-short position will be a loser. There is no risk-free arbitrage between the liquid and illiquid bottles.

While the differential between detergent bottle liquidity premia cannot be arbitraged away, it can be slowly competed away by other detergent products. But it is by no means an inevitability that this will occur. Building up a liquidity network takes time and resources. All sorts of money must be thrown at wrestling away the loyalties and fixed behaviors of the transacting public. The physical infrastructure to underpin the network must also be sufficient to meet demands. If a new company comes out with a bottled detergent product, it doesn't matter how snappy its advertising campaigns is if there is no distribution system to move product from A to B. All of these large fixed costs help to keep existing liquidity premia in place.

Detergent bottle liquidity premia can disappear entirely. If it becomes illegal to pass on bottles, they would lose their liquidity and no longer earn a premium. Substitutes like shampoo bottles would be bought for their liquidity yield. More interestingly, say people become so sure about the future that inventories of potentially saleable goods no longer provide any useful services. With no uncertainty, liquidity is worthless and all liquidity premia fall to 0. Because we do face some level of uncertainty in the real world, we value liquidity and put a premium on more-liquid goods like Tide detergent bottles. Individual premia are probably constantly shifting, but the society-wide aggregate liquidity premium probably stays fairly constant.

6 comments:

Someone who wanted to wash clothes would buy Cheer instead of Tide. That's a form of arbitrage. Also, as people started to trade with paper claims to Tide rather than with Tide itself, part of Tide's liquidity premium would be lost. This would create some arbitrage profits for the people who issued the claims to Tide.

Mike, when I think of arbitrage I usually assume some sort of dual transaction that yields an immediate risk free profit.

There is no guarantee that issuance of paper claims to Tide will start to trade in a way that replaces Tide in transactions, since as I pointed out in my post, it takes time and resources to build up liquidity networks. If Tide claims do start to compete with Tide bottles for transactions, than we'll see a redistribution of the net liquidity premium rather than an all out loss of the liquidity premium.

Just thought of this post when I walked into a CVS in NYC and all the detergent bottles (Tide and otherwise) were attached to antitheft devices! I did not see any other items in the store that were protected in such a way..